Definition
A defined contribution plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.
Defined-Contribution Plan
Under a Defined-Contribution Plan a certain percentage or amount of money is put aside by a company every year for the benefit of the employee. However, a Defined-Contribution Plan does not promise to pay a specific amount of money upon retirement. In other words, there is no way of knowing exactly how much an employee will get when they retire, because while the contributed amount is set each year, the benefit is not.
While a Defined-Contribution Plan is sometimes referred to as a pension, but it’s nothing like it in reality. The word ‘pension’ is defined as a fixed amount that is paid at regular intervals to a person or their surviving dependants, in consideration of past services rendered. In comparison, a Defined-Contribution Plan is an arrangement in which an employer puts money in a registered retirement account on behalf of their employee. When compared to a pension, a Defined-Contribution Plan offers a lesser obligation for the employer and less security for the employee.
How it works?
The employer will allocate contributions to an employee’s account several times in the form of matching contributions. As an employee, you are allowed to make contributions to your account under the Defined-Contribution Plan. The retirement benefit that is payable to the employee will solely depend on the balance in the account upon retirement.
In a Defined-Contribution Plan the investment risks and rewards are assumed by each employee, and not by the employer. This means that the risk may be substantial. In fact, according to a study, a considerable amount of variation has been found in the fund ratios of Defined-Contribution Plans across several countries. While the participant in a Defined-Contribution Plan has control over the investment decisions, it is the sponsor or employer who retains most of the fiduciary responsibility over the investment options.
Since employers have found the Defined Benefit Plan to be more expensive as compared to a Defined-Contribution Plan, many organizations have scaled back or eliminated the latter entirely in the past decade. So, if your company still has a Defined Benefit Plan you should consider yourself lucky.
Further Reading
- Remaking retirement investors: behavioural economics and defined-contribution occupational pensions – www.tandfonline.com [PDF]
- The value and risk of defined contribution pension schemes: international evidence – onlinelibrary.wiley.com [PDF]
- Employee saving and investment decisions in defined contribution pension plans: survey evidence from the UK – papers.ssrn.com [PDF]
- Optimal management under stochastic interest rates: the case of a protected defined contribution pension fund – www.sciencedirect.com [PDF]
- Naive diversification strategies in defined contribution saving plans – www.aeaweb.org [PDF]
- Pension funds: retirement-income security and capital markets: an international perspective – ideas.repec.org [PDF]
- Non-financial defined contribution pensions: Mapping the terrain – elibrary.worldbank.org [PDF]
- The economics of social security reform – www.nber.org [PDF]
